In this video, I want to talk about before we get into the specifics throughout this course and this section on entering trades, just talk about our logic and thought the process of how we go about making trades and just a 10,000-foot view of what we’re trying to do.
It’s obviously a game of numbers, and I’ve often said that when it comes to options trading, we should run our business much like a casino does. We all know that casinos make money, they make money hand over fist, but it's sometimes hard to step back and to find out exactly where their edge is.
We know that casinos make money, and they have an edge, and they want us to play, but let’s quantify that. What does that look like and what are the mechanics and logistics behind that because there’s much more to it than just the percentage that they’re going to win or lose on a given trade or a table game.
It comes down to sizing, table limits, the number of times that people play or roll the dice. There’s a lot that goes into it, and we should act much like a casino does, but we often do the complete opposite, and you’ll see why.
How does a casino make money and what's their edge that they have over us? How do we quantify that? Let’s start with roulette. Admittedly, roulette is one of the worst odds games, but it’s one my favorite ones to play.
I mean, go figure. I like playing it, and I don’t go there to make money. But when I go, I like to play roulette. I don’t follow all the things with poker and the different players at the table. I just like to play roulette and bet on the different numbers and spaces.
But when it comes to roulette, (and we know that game with the wheel that spins and the marble that falls) most often, people will bet on red or black and it’s pretty normal for somebody to go to a casino and just put all their money or red or black or whatever the case is.
But here’s the exact way that it’s paid out. You can see the payout is 1:1. That means if you bet $1, they’ll pay you $1 if you win and if you bet $1 and you lose, you lose $1. That’s how the payout works. It’s pretty fair as far as risk and reward. You put up $50; you could make $50 or lose $50.
But here's where the casino’s edge comes into play, and there are two different ones. There’s the European probability which European roulette wheels only have one green zero, and they do a little bit better as far as a probability.
Us Americans, we get hammered, and we have two double zeros on our roulette wheel, and that means that our probability is even lower. But you can see that the probability of this happening, either one of these, red or black is just about 48% to 47%.
Even though you're making $1 for every $1 you put up at risk, the likelihood of you keeping that is 47% which means that the casino’s edge is somewhere around 2.5% to 3%. That’s how we can find out what the casino’s edge is because every time that we make this trade, theoretically, we’re losing about 2.5% to 3%.
It’s not a lot. It’s not like the casino is robbing you of your money immediately. But over time, you can see how this grows. And you can see the number of total times it can happen and the colors and everything and the numbers that are covered in this.
As we go down on the roulette odds, you can see that probability of red or black is about 46%, 47% depending on how you calculate it and who you look at and the number of occurrences.
But you can see that the odds of that are happening even with just even numbers that have 1:1 payouts are pretty much the same. The casino is not going to rake you over the calls and take all your money at once.
They want you to stay longer, and they want you to play longer. And then obviously, as you get further and further down, the probability of hitting any one number on the roulette wheel decreases dramatically, but the payout is obviously a lot higher. Instead of being 1:1, they’ll payout 35:1.
If you put up $1 in money to bet and you hit it, you’re going to make about $35 for every $1 that you put up. The big payout, but it’s got a very small likelihood of actually happening.
Why table limits? You’ve often heard that when you go to a casino that the casino will have a little sign posted there that says that this table has a table limit or a bet limit of say $50 or $100.
Having table limits increases the number of “plays” that a person will make which thus increases the house edge back to the casino. The longer you play, the more you stand to lose and that’s period, end of the story, there’s no debating it.
Casino’s deliberately wants you to make lots of plays and play a lot, and they want you to do it with a small amount of money. I often say, and I’ve done a podcast on this too, is that if you walked into a casino and you told the casino manager, “I want to bet $1 million on red right now. One bet, $1 million on red, one roll, one spin and that’s it.”
And they would hand down say, “No way.” 99% of casinos would say “Absolutely no way” because their one-time probability of losing on that bet is about 47% that they’re going to lose to you, so it’s too big of a bet in one full swoop.
What they would want to see is they want to see you spread that $1 million over thousands of different bets. They limit the amount of money that you can bet on any one roll or any one play because they know that the more you spin, the more you roll, the more behind that you become.
Here's a great chart that shows this and this is with roulette, the odds of going with a black or red or even an odd number, so just one spin. If you spin it one time and the wheel goes around one time, you’re likely to be behind on average about 51%.
Remember, you’re getting paid 50/50 if you win, so your risk is almost the same as your reward payout wise. Over the course of 100 spins, the percentage that you would get behind is about 64%, so you’re still in the game here, you’ve been playing for a while, but now you’re starting to lose more and more of that edge to the casino.
And over 1,000 spins then over more importantly 10,000 spins, you can see that on a given night, over 10,000 spins, you have no chance of keeping any of the money that you started with.
The longer you play, the less consistent you become. In fact, consistency drops exponentially the longer that you play because that small house edge that we looked at before, 2.5% to 3% slowly goes back to the casino.
And this is why they want us to play longer and longer. This is why they have great deals on casino trips, and they offer you free rooms and free food because the longer you play, the more money that’s going to get sacked back to them.
Having said all of this, as traders and more importantly as options traders, we need to follow the same logic with how we run our business and you have to think of it as a business, to begin with. This isn’t a hobby. This is something you do on the side.
You have to run this thing like a business and that means that you have to one, make high probability trades. When you go to a casino, you’re not making any high probability trades. There’s a small edge to the house. In trading, we know how to make high probability trades, and we can do that.
Number two is we’ve got to keep our position size small. We’ve got to set table limits for ourselves. We can’t go in there like I often say like a rodeo cowboy just slinging money around left and right.
You got to go in there, and you got to make small bets based on your position size. We’ve got a great guide inside Option Alpha in the guides and checklist section that helps you determine your position size based on a bunch of different account sizes.
And number three, we have to understand that consistency is what leads to profits, so being able to make high probability trades with small positions over a long stretch of time. And going back to the casino example, they didn’t have a 100% chance of success in winning until they had 10,000 spins.
That doesn't mean that we’ve got to make 10,000 trades, but that does mean that one or even 100 trades over the course of a year may not get us to that consistency level that we want, but we’re assured that if we keep making high probability trades and keep setting table limits for ourselves that we will see success the longer and longer we stay in it.
That's why guys in this business who have been in it five years and ten years become more and more successful because they’ve just made more trades. If they stay consistent and persistent, it will lead to profits.
Hopefully this has been a really good tutorial just to get you started before we get into a lot of the logistics of entering trades and how to manage some of those entry points and looking for trades. It's important to take a step back and understand the 10,000-foot view of what we’re trying to do here.
As always, if you guys enjoy this video, please share it online, on Twitter, on Facebook. Add a comment right below this video in the lesson page if you have any questions. I’ll make sure I get back to all of those. Happy trading!